Flashback to the future

Worries about the threat to “monetary sovereignty” from cryptocurrencies are based on outdated thinking.

You may have seen recently that the Reserve Bank has been talking about the idea of a Central Bank Digital Currency, or CBDC. This project has been going for a couple of years, and it’s still very much in the exploration stage - if it makes it to market at all, it probably won’t be before 2030, and there will likely be several more rounds of public consultations along the way. If you want to know more, I recommend starting with this interview by Madison Reidy - it gives a good sense of what’s being proposed, as well as the kinds of questions that people are asking about it.

The first and most obvious question is: Why? The Reserve Bank lists a number of potential benefits: an alternative to the declining use and availability of physical cash, a backup when other payment methods are disrupted, a way to provide for the ‘unbanked’, or a spur for innovation in the financial sector. “Potential” is the crucial word here; the extent to which any of these benefits are realised will depend on the degree of uptake by both users and financial service providers.

Another of the cited benefits was something more directly of interest to the Reserve Bank itself: that it could help to ward off threats to our “monetary sovereignty”. What does this mean? The name suggests it’s to do with a nation’s ability to issue its own money, though there’s a bit more to it than that. In this case, it refers to the ability to conduct our own monetary policy, which these days means the ability to set our own interest rates separately from the rest of the world.

The concern for central banks is the rise of privately-issued forms of money, namely cryptocurrencies such as Bitcoin and Ethereum. If people adopted these widely, central banks’ ability to set interest rates and transmit them through to the wider economy could be greatly reduced. And that would leave them with desperately few tools for achieving one of their primary purposes - managing inflation. Hence, the thinking goes, issuing a CBDC would help them to stay relevant, by keeping them at the forefront of how people use money.

Reading about these concerns, my mind immediately flashed to an RBNZ paper from 2001 by Bruce White, titled “Central Banking: Back to the Future”. Not because I have an encyclopaedic knowledge of these things, but because the paper (and Bruce) came along early in my career at the RBNZ, when I was still young and impressionable.

Bruce’s paper is an attempt to answer the question: what makes central banks special? Now this is probably not a question that would keep most people awake at night. A central bank is a creation of government; it has legislation granting it the powers to do what it needs to do. Case closed, surely.

But it turns out that it’s not so simple. For example, the RBNZ can set the Official Cash Rate, which is a one-day or ‘overnight’ interest rate. But it can’t compel anyone to borrow from or lend to it. What’s to stop private businesses from just dealing among themselves, determining their own interest rates, and leaving the central bank out of the loop?

One of the typical answers given is that the central bank has an ‘anchor client’: the government itself. The story goes that the government will only make or accept payments in legal tender, and since everyone will end up having dealings with the government at some point - such as when they pay tax - there will always be a need for the private sector to hold some base level of central bank money.

But as Bruce notes, there’s something unsatisfying about this answer. What if the government decided to accept other forms of payment, such as US dollars? Would the RBNZ then lose the ability to conduct monetary policy? Is its command over the economy really that fragile?

What’s more, it reflects an outdated view of how monetary policy is conducted. In introductory textbooks, you’ll often see descriptions of central banks tightening or loosening policy by changing the availability of money, with the price (the interest rate) doing the adjusting to match demand with supply. But over time, central banks have converged on the opposite approach: they fix the price at a certain level, and the the quantity of money is determined by the market. In this version, there’s no requirement to hold any amount of central bank money at all.

So what gives central banks the power to set interest rates? Bruce’s answer is that it comes from their effectively unlimited balance sheet. Here’s a greatly simplified example with numbers. Let’s say that the RBNZ has set the OCR at 5% and expects to hold it at that level for some time. Then MegaBank comes along and says that it thinks the overnight rate should actually be 4%, and that it’s willing to deal with anyone at that rate.

What’s going to happen? Every other bank will borrow from MegaBank at 4%, then deposit the cash at the RBNZ, which will accept it without limit at a rate of 5%, earning a guaranteed profit of 1%. MegaBank will eventually run out of cash to lend, and will either have to relent or go bust.

It’s a similar story if MegaBank sets its interest rate at 6%. Other banks will borrow from the RBNZ (which can lend without limit) at 5%, and deposit it at MegaBank at 6%, again earning a guaranteed 1% profit. MegaBank will be left with more cash than it can make use of - the best it can do is re-deposit it at the RBNZ at 5%, making a loss of 1%. Again, it will eventually have to relent and pay a lower rate.

In this way, the RBNZ can set the overnight cash rate simply by standing in the market at a fixed rate, and allowing arbitrage to propagate that rate through to other interest rates. Indeed, the RBNZ may not even need to deal with banks at all; the mere prospect of arbitrage is enough to bring their interest rates into line with the RBNZ.

So what gives central banks the power to determine interest rates is their effectively unlimited balance sheet. While the RBNZ may only set the interest rate on ‘New Zealand dollars’, any asset that trades 1:1 with New Zealand dollars will be subject to the same forces. That’s not something that a private form of money can match, and makes it very difficult - though not impossible - for a country to lose its “monetary sovereignty”.

You might argue that this is all coming from a paper written in 2001; surely cryptocurrencies have changed the game since then. Actually, no. Economists didn’t predict the exact details of Bitcoin, such as the blockchain or the decentralised ledger that underpins it. But they did foresee that the rise of digital technology could allow for the emergence of multiple, privately issued currencies. For instance, here’s Mervyn King, the deputy governor of the Bank of England, in 1999:

…at some future time, people might have palm-held computers which enable prices to be denominated, and transactions settled, in a wide range of financial instruments for which there are market prices (and thus a whole array of readily knowable “exchange rates”). That world would be one in which many “currencies” - all those things used in settling exchange - would circulate within the local economy, in parallel. It would represent a step towards a world without money, that is, a world in which many things - in the limit, everything - could serve as money.

It’s not an exact description, but that sounds much like a crypto wallet held on your phone. But the issue is not whether the technology allows you to do something, but whether people are willing to do it.

As the quote above hints, people who use multiple currencies face exchange rate risk. If you want to buy things with Bitcoin, but your salary is paid in New Zealand dollars, you run the risk that the NZD/Bitcoin exchange rate moves against you. The people who already use Bitcoin are obviously fine with taking that risk, but many of us would be uncomfortable with the idea that market movements could make the grocery or power bill unaffordable for that month.

You can reduce that risk if you could persuade your employer to pay you in Bitcoin as well. But that just shifts the risk onto the employer. Unless they can also sell their products in Bitcoin, and convince their suppliers to be paid in Bitcoin… and so on. Abandoning the national currency really looks like an all-or-nothing prospect, and most people would need a very strong reason to do so.

Indeed, the examples where this has arguably happened are the basket cases - the ones who have so thoroughly trashed the value of their own currencies, the only way to restore some trust is to adopt a currency that they can’t manipulate. That includes Ecuador, El Salvador and Zimbabwe, which have adopted other countries’ currencies such as the US dollar at various times. You also have cases like Venezuela, where there’s still an official currency but people will use it only when they have to, otherwise converting their savings into US dollars as soon as they can.

I’m not sure that this is the kind of scenario that central banks should be making plans for. Nor is it obvious that a CBDC would be a solution - especially since its value would be pegged to the existing currency. One of the few examples of a country that has introduced a CBDC is Nigeria, which launch the eNaira in 2021. The uptake so far has been extremely low, in part because people don’t trust the government to maintain the value of this new currency any better than they’ve done with the existing one.

So, while not ruling out the possibility that cryptocurrencies could displace national currencies, the hurdle for this to happen is extremely high. Today, monetary policy is run in a way that doesn’t depend on the amount of central bank money that’s used - its mere existence is what gives it sway. And in part, Bruce’s paper serves to show that concerns about central banks losing their mojo are based on thinking that was out of date even in 2001 - let alone today.